Bankers: Rethink Risk and Start Lending Again!

People who need credit the most are getting denied because banks consider them too risky.

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While a whole lot of folks are obsessed with what to do about, or to, the 1%, I would like to focus on an issue involving the 90%. This isn't about the wealth or income gap. It's about the credit gap. It's driving the Fed crazy and stifling the economy.

Here's the problem. Right now, banks are lending the bulk of mortgage money to people who have great credit, but are less likely to spend the money they save. As the Wall Street Journal reported this week, the people who need credit the most — middle-class families who are the drivers of the American economy — get denied because banks consider them too risky.

"Last year, nearly 90% of all new mortgages originated went to households with high credit scores; before the financial crisis, it was about half," the Journal reported.

The Journal also noted that the trend was ameliorating somewhat with respect to certain kinds of consumer debt, such as car loans and credit cards. Of course, that is precisely what you would expect given the fact that a lender's return on car loans is much more attractive than the equivalent return on mortgages, and neither compare to the sky-high rates earned by credit card issuers. Furthermore, credit card limits are much lower and can be closed with little notice while car loans are pleasantly short-term, compared to the long-term and large-sized risk of a mortgage.

For generations of middle-class Americans, the 30-year fixed-rate mortgage has been the primary building block of wealth and economic stability. Unfortunately for millions, that superhighway to the Promised Land has now become a parking lot. The job loss, missed payments, foreclosed homes and trashed credit scores caused by the financial crisis have created a permanent, disenfranchised class. A significant swath of the American public is, in effect, separated from the benefits of a modern financial system — unemployed, little or no access to credit, home ownership threatened.

Even as this problem deepens, the government's traditional method of increasing credit availability is already tapped out. The Federal Reserve is practically giving away money to institutions, keeping interest rates close to zero. The Fed has again confirmed that rates will stay that way through at least 2014. While I believe that policy is important to maintain, I don't believe that it can or will have any impact on the credit gap as things stand now.

We need a meaningful private sector solution. Now I'm not advocating that banks lower their lending standards, which they did during the housing bubble to create fake demand and keep the spigots of mortgage fee revenue flowing. Rather, banks need to adopt new ways to recognize who is credit-worthy and who is not. That's because current credit scoring models, based upon traditional credit report data sets, can't help banks identify millions of potential customers who are perfectly trustworthy and deserving of credit.

Let's face it, the Great Recession didn't just hurt scammers who took out half-million-dollar loans for McMansions using no-document "liar" loans. Millions of innocent people were crushed and millions more are denied access to credit due to insufficient information and tighter restrictions.